Chapter 18

Distributions to Shareholders:
Dividends and Repurchases
ANSWERS TO END-OF-CHAPTER QUESTIONS

18-1

a. The optimal dividend policy is the dividend policy that strikes a

balance between current dividends and future growth and maximizes the
firm s stock price.
b. The dividend irrelevance theory holds that dividend policy has no
effect on either the price of a firms stock or its cost of capital.
The principal proponents of this view are Merton Miller and Franco
Modigliani (MM). They prove their position in a theoretical sense, but
only under strict assumptions, some of which are clearly not true in
the real world. The bird-in-the-hand theory assumes that investors
value a dollar of dividends more highly than a dollar of expected
capital gains because the dividend yield component, D1/P0, is less risky
=
than the g component in the total expected return equation k
s
D1/P0 + g.
The tax preference theory proposes that investors prefer
capital gains over dividends, because capital gains taxes can be
deferred into the future, but taxes on dividends must be paid as the
dividends are received.
c. The information content of dividends is a theory which holds that
investors regard dividend changes as signals of management forecasts.
Thus, when dividends are raised, this is viewed by investors as
recognition by management of future earnings increases. Therefore, if a
firms stock price increases with a dividend increase, the reason may
not be investor preference for dividends, but expectations of higher
future earnings.
Conversely, a dividend reduction may signal that
management is forecasting poor earnings in the future. The clientele
effect is the attraction of companies with specific dividend policies
to those investors whose needs are best served by those policies.
Thus, companies with high dividends will have a clientele of investors
with low marginal tax rates and strong desires for current income.
Similarly, companies with low dividends will attract a clientele with
little need for current income, and who often have high marginal tax
rates.
d. The residual dividend model states that firms should pay dividends only
when more earnings are available than needed to support the optimal
capital budget.
e. An extra dividend is a dividend paid, in addition to the regular
dividend, when earnings permit. Firms with volatile earnings may have

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Answers and Solutions: 18- 1

a low regular dividend that can be maintained even in low-profit (or

high capital investment) years, and then supplement it with an extra
dividend when excess funds are available.
f. The declaration date is the date on which a firm s directors issue a
statement declaring a dividend. If a company lists the stockholder as
an owner on the holder-of-record date, then the stockholder receives
the dividend. The ex-dividend date is the date when the right to the
dividend leaves the stock. This date was established by stockbrokers
to avoid confusion and is 4 business days prior to the holder of record
date. If the stock sale is made prior to the ex-dividend date, the
dividend is paid to the buyer. If the stock is bought on or after the
ex-dividend date, the dividend is paid to the seller.
The date on
which a firm actually mails dividend checks is known as the payment
date.
g. Dividend reinvestment plans allow stockholders to automatically
purchase shares of common stock of the paying corporation in lieu of
receiving cash dividends. There are two types of plans--one involves
only stock that is already outstanding, while the other involves newly
issued stock. In the first type, the dividends of all participants are
pooled and the stock is purchased on the open market. Participants
benefit from lower transaction costs. In the second type, the company
issues new shares to the participants. Thus, the company issues stock
in lieu of the cash dividend.
h. In a stock split, current shareholders are given some number (or
fraction) of shares for each stock owned. Thus, in a 3-for-1 split,
each shareholder would receive 3 new shares in exchange for each old
share, thereby tripling the number of shares outstanding. Stock splits
usually occur when the stock price is outside of the optimal trading
range. Stock dividends also increase the number of shares outstanding,
but at a slower rate than splits.
In a stock dividend, current
shareholders receive additional shares on some proportional basis.
Thus, a holder of 100 shares would receive 5 additional shares at no
cost if a 5 percent stock dividend were declared.
i. Stock repurchases occur when a firm repurchases its own stock. These
shares of stock are then referred to as treasury stock. The higher EPS
on the now decreased number of shares outstanding will cause the price
of the stock to rise and thus capital gains are substituted for cash
dividends.
18-2

a. From the stockholders point of view, an increase in the personal

income tax rate would make it more desirable for a firm to retain and
reinvest earnings. Consequently, an increase in personal tax rates
should lower the aggregate payout ratio.
b. If the depreciation allowances were raised, cash flows would increase.
With higher cash flows, payout ratios would tend to increase. On the
other hand, the change in tax-allowed depreciation charges would
increase rates of return on investment, other things being equal, and

Answers and Solutions: 18 - 2

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this might stimulate investment, and consequently reduce payout ratios.

On balance, it is likely that aggregate payout ratios would rise, and
this has in fact been the case.
c. If interest rates were to increase, the increase would make retained
earnings a relatively attractive way of financing new investment.
Consequently, the payout ratio might be expected to decline. On the
other hand, higher interest rates would cause kd, ks, and firms MCCs to
rise--that would mean that fewer projects would qualify for capital
budgeting and the residual would increase (other things constant),
hence the payout ratio might increase.
d. A permanent increase in profits would probably lead to an increase in
dividends, but not necessarily to an increase in the payout ratio. If
the aggregate profit increase were a cyclical increase that could be
expected to be followed by a decline, then the payout ratio might fall,
because firms do not generally raise dividends in response to a shortrun profit increase.
e. If investment opportunities for firms declined while cash inflows
remained relatively constant, an increase would be expected in the
payout ratio.
f. Dividends are currently paid out of after-tax dollars, and interest
charges from before-tax dollars.
Permission for firms to deduct
dividends as they do interest charges would make dividends less costly
to pay than before and would thus tend to increase the payout ratio.
g. This change would make capital gains less attractive and would lead to
an increase in the payout ratio.
18-3

The biggest advantage of having an announced dividend policy is that it

would reduce investor uncertainty, and reductions in uncertainty are
generally associated with lower capital costs and higher stock prices,
other things being equal. The disadvantage is that such a policy might
decrease corporate flexibility.
However, the announced policy would
possibly include elements of flexibility. On balance, it would appear
desirable for directors to announce their policies.

18-4

It is sometimes argued that there is an optimum price for a stock; that

is, a price at which k will be minimized, giving rise to a maximum price
for any given earnings. If a firm can use stock dividends or stock splits
to keep its shares selling at this price (or in this price range), then
stock dividends and/or splits will have helped maintain a high P/E ratio.
Others argue that stockholders simply like stock dividends and/or splits
for psychological or some other reasons. If stockholders do like stock
dividends, using them would have the effect of keeping P/E ratios high.
Finally, it has been argued (by Barker) that increases in the number of
shareholders accompany stock dividends and stock splits. One could, of
course, argue that no causality is contained in this relationship. In
other words, it could be that growth in ownership and stock splits is a
function of yet another variable.

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Answers and Solutions: 18- 3

18-5

The difference is largely one of accounting. In the case of a split, the

firm simply increases the number of shares and simultaneously reduces the
par or stated value per share. In the case of a stock dividend, there
must be a transfer from retained earnings to capital stock.
For most
firms, a 100 percent stock dividend and a 2-for-1 split accomplish exactly
the same thing; hence, investors may choose either one.

18-6

While it is true that the cost of outside equity is higher than that of
retained earnings, it is not necessarily irrational for a firm to pay
dividends and sell stock in the same year. The reason is that if the firm
has been paying a regular dividend, and then cuts it in order to obtain
equity capital from retained earnings, there might be an unfavorable
effect on the firms stock price.
If investors lived in the world of
certainty and rationality postulated by Miller and Modigliani, then the
statement would be true, but it is not necessarily true in an uncertain
world.

18-7

Logic suggests that stockholders like stable dividends--many of them

depend on dividend income, and if dividends were cut, this might cause
serious hardship. If a firms earnings are temporarily depressed or if it
needs a substantial amount of funds for investment, then it might well
maintain its regular dividend, using borrowed funds to tide it over until
things returned to normal.
Of course, this could not be done on a
sustained basis--it would be appropriate only on relatively rare
occasions.

18-8

It is true that executives salaries are more highly correlated with the
size of the firm than with profitability. This being the case, it might
be in managements own best interest (assuming that management does not
have a substantial ownership position in the firm) to see the size of the
firm increase whether or not this is optimal from the stockholders point
of view. The larger the investment during any given year, the larger the
firm will become. Accordingly, a firm whose management is interested in
maximizing the size of the firm rather than the value of the existing
common stock might push investments down below the cost of capital. In
other words, management might invest to a point where the marginal return
on new investment is less than the cost of capital.
If the firm does invest to a point where the return on investment is
less than the cost of capital, the stock price must fall below what it
otherwise would have been.
Stockholders would be given additional
benefits from the higher retained earnings, and this might well push up
the stock price, but the increase in stock price would be less than the
value of dividends received if the company had paid out a larger
percentage of its earnings.

18-9

a. MM argue that dividend policy has no effect on ks, thus no effect on

firm value and cost of capital.
On the other hand, GL argue that
investors view current dividends as being less risky than potential
future capital gains. Thus, GL claim that ks is inversely related to
dividend payout. See text Figure 18-1 for a graphic representation of
the two positions.

Answers and Solutions: 18 - 4

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b. The tax preference theory supports the view that since capital gains
are deferred and are effectively taxed at lower rates (at a rate of 20
percent) than dividend income, investors value capital gains more
highly than dividends. Thus, the tax preference theory states that ks
is directly related to dividend payout.
c. Unfortunately, empirical tests have failed
support for any of the dividend theories.

to

offer

overwhelming

d. MM could claim that tests which show that increased dividends lead to
increased stock prices demonstrate that dividend increases are causing
investors to revise earnings forecasts upward, rather than cause
investors to lower ks. MMs claim could be countered by invoking the
efficient market hypothesis. That is, dividend increases are built
into expectations and dividend announcements could lower stock price,
as well as raise it, depending on how well the dividend increase
matches expectations.
Thus, a bias towards price increases with
dividend increases supports GL.
e. Since there are clients who prefer different dividend policies, MM
could argue that one policy is as good as another.
But, if the
clienteles are of differing sizes or economic means, the clienteles
might not be equal, and one dividend policy could be preferential to
another.
18-10 The stock market was strong and stock prices rose significantly in 1983;
thus many firms stock prices rose above the optimal $20-$80 range.
Firms were then inclined to use stock splits or dividends to return stock
price to the range where firm value was maximized.
There is widespread belief that there is an optimal price range for
stocks.
By optimal, it means that if the stock price is within this
range, the P/E ratio, and hence the value of the firm, will be maximized.
Stock splits and stock dividends can be used for this purpose.
18-11 a. The residual dividend policy is based on the premise that, since new
common stock is more costly than retained earnings, a firm should use
all the retained earnings it can to satisfy its common equity
requirement. Thus, the dividend payout under this policy is a function
of the firms investment opportunities.
b. Yes. A more shallow plot implies that changes from the optimal capital
structure have little effect on the firms cost of capital, hence
value. In this situation, dividend policy is less critical than if the
plot were V-shaped.
18-12 a. True.
When investors sell their stock they are subject to capital
gains taxes.
b. True. If a companys stock splits 2 for 1, and you own 100 shares,
then after the split you will own 200 shares.
c. True.

Dividend reinvestment plans that involve newly issued stock will

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Answers and Solutions: 18- 5

increase the amount of equity capital available to the firm.

d. False.
The tax code, through the tax deductibility of interest,
encourages firms to use debt and thus pay interest to investors rather
than dividends, which are not tax deductible. In addition, due to a
lower capital gains tax rate than the highest personal tax rate, the
tax code encourages investors in high tax brackets to prefer firms who
retain earnings rather than those that pay large dividends.
e. True. If a companys clientele prefers large dividends, the firm is
unlikely to adopt a residual dividend policy.
A residual dividend
policy could mean low or zero dividends in some years which would upset
the companys developed clientele.
f. False.
If a firm follows a residual dividend policy, all else
constant, its dividend payout will tend to decline whenever the firms
investment opportunities improve.

Answers and Solutions: 18 - 6

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SOLUTIONS TO END-OF-CHAPTER PROBLEMS

18-1

70% Debt; 30% Equity; Capital Budget = $3,000,000; NI = $2,000,000;

PO = ?
Equity retained = 0.3($3,000,000) = $900,000.
NI
-Additions
Earnings Remaining
Payout =

18-2

$1,100,000
$2,000,000

P0 = $90; Split = 3 for 2; New P0 = ?

P0

18-3

$2,000,000
900,000
$1,100,000

New

$90
= $60.
3/ 2

NI = $2,000,000; Shares = 1,000,000; P0 = $32; Repurchase = 20%;

New P0 = ?
Repurchase = 0.2 1,000,000 = 200,000 shares.
Repurchase amount = 200,000 $32 = $6,400,000.
P/E =

$32
= 16.
$2

EPSOld =

NI
$2,000,000
=
= $2.00.
Shares
1,000,000

EPSNew =

$2,000,000
$2,000,000
=
= $2.50.
1,000,000 200,000
800,000

PriceNew = EPSNew P/E = $2.50(16) = $40.

18-4

Retained earnings = Net income (1 - Payout ratio)

= $5,000,000(0.55) = $2,750,000.
External equity needed:
Total equity required = (New investment)(1 - Debt ratio)
= $10,000,000(0.60) = $6,000,000.

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Answers and Solutions: 18- 7

18-5

18-6

New external equity needed = $6,000,000 - $2,750,000 = $3,250,000.

The company requires 0.40($1,200,000) = $480,000 of equity financing. If
the company follows a residual dividend policy it will retain $480,000 for
its capital budget and pay out the $120,000 residual to its shareholders
as a dividend. The payout ratio would therefore be $120,000/$600,000 =
0.20 = 20%.

Equity financing = $12,000,000(0.60) = $7,200,000.

Dividends = Net income - Equity financing
= $15,000,000 - $7,200,000 = $7,800,000.
Dividend payout ratio = Dividends/Net income
= $7,800,000/$15,000,000 = 52%.

18-7

DPS after split = $0.75.

Equivalent pre-split dividend = $0.75(5) = $3.75.
New equivalent dividend = Last years dividend(1.09)
$3.75 = Last years dividend(1.09)
Last years dividend = $3.75/1.09 = $3.44.

18-8

Capital budget should be $10 million. We know that 50% of the $10 million
should be equity. Therefore, the company should pay dividends of:
Dividends = Net income - needed equity
= $7,287,500 - $5,000,000 = $2,287,500.
Payout ratio = $2,287,500/$7,287,500 = 0.3139 = 31.39%.

18-9

a. 1. 2002 Dividends = (1.10)(2001 Dividends)

= (1.10)($3,600,000) = $3,960,000.
2. 2001 Payout = $3,600,000/$10,800,000 = 0.33 = 33%.
2002 Dividends = (0.33)(1999 Net income)
= (0.33)($14,400,000) = $4,800,000.
(Note: If the payout ratio is rounded off to 33%, 2002 dividends
are then calculated as $4,752,000.)
3. Equity financing = $8,400,000(0.60) = $5,040,000.
2002 Dividends = Net income - Equity financing
= $14,400,000 - $5,040,000 = $9,360,000.
All of the equity financing is done with retained earnings as long

Answers and Solutions: 18 - 8

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as they are available.

4. The regular dividends would be 10% above the 2001 dividends:
Regular dividends = (1.10)($3,600,000) = $3,960,000.
The residual policy calls for dividends of $9,360,000. Therefore,
the extra dividend, which would be stated as such, would be
Extra dividend = $9,360,000 - $3,960,000 = $5,400,000.
An even better use of the surplus funds might be a stock repurchase.
b. Policy 4, based on the regular dividend with an extra, seems most
logical. Implemented properly, it would lead to the correct capital
budget and the correct financing of that budget, and it would give
correct signals to investors.
c. ks =

d.

D1
P0

+ g =

$9,000,000
+ 10% = 15%.
$180,000,000

g = b(ROE)
0.10 = (1 - $3,600,000/$10,800,000)(ROE)
ROE = 0.10/0.6667 = 0.15 = 15%.

e. A 2002 dividend of $9,000,000 may be a little low. The cost of equity

is 15%, and the average return on equity is 15%.
However, with an
average return on equity of 15%, the marginal return is lower yet.
That suggests that the capital budget is too large, and that more
dividends should be paid out. Of course, we really cannot be sure of
this--the company could be earning low returns (say 10%) on existing
assets yet have extremely profitable investment opportunities this year
(say averaging 30%) for an expected overall average ROE of 15%. Still,
if this years projects are like those of past years, then the payout
appears to be slightly low.

18-10 a. Capital Budget = $10,000,000; Capital structure = 60% equity, 40% debt.
Retained Earnings Needed = $10,000,000 (0.6) = $6,000,000.
b. According to the residual dividend model, only $2 million is available
for dividends.
NI - Retained earnings needed for cap. projects = Residual dividend.
$8,000,000 - $6,000,000 = $2,000,000.
DPS = $2,000,000/1,000,000 = $2.00.
Payout ratio = $2,000,000/$8,000,000 = 25%.
c. Retained Earnings Available = $8,000,000 - $3.00 (1,000,000)
Retained Earnings Available = $8,000,000 - $3,000,000

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Answers and Solutions: 18- 9

Retained Earnings Available = $5,000,000.

d. No.
If the company maintains its $3.00 DPS, only $5 million of
retained earnings will be available for capital projects. However, if
the firm is to maintain its current capital structure, $6 million of
equity is required. This would necessitate the company having to issue
$1 million of new common stock.
e. Capital Budget = $10 million; Dividends = $3 million; NI = $8 million.
Capital Structure = ?
RE Available = $8,000,000 - $3,000,000
= $5,000,000.
Percentage of Cap. Budget Financed with RE =

$5,000,000
= 50%.
$10,000,000

Percentage of Cap. Budget Financed with Debt =

$5,000,000
= 50%.
$10,000,000

f. Dividends = $3 million; Capital Budget = $10 million; 60% equity, 40%

debt; NI = $8 million.
Equity Needed = $10,000,000(0.6) = $6,000,000.
RE Available = $8,000,000 - $3.00(1,000,000)
= $8,000,000 - $3,000,000
= $5,000,000.
External (New) Equity Needed = $6,000,000 - $5,000,000
= $1,000,000.
g. Dividends = $3 million; NI = $8 million; Capital structure = 60%
equity, 40% debt.
RE Available = $8,000,000 - $3,000,000
= $5,000,000.
Were forcing the RE Available = Required Equity to find the new
capital budget.
Required Equity = Capital Budget (Target Equity Ratio)
$5,000,000 = Capital Budget(0.6)
Capital Budget = $8,333,333.
Therefore, if Buena Terra cuts its capital budget from $10 million to
$8.33 million, it can maintain its $3.00 DPS, its current capital
structure, and still follow the residual dividend policy.
h. The firm can do one of four things:

Answers and Solutions: 18 - 10

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(1)
(2)
(3)
(4)

Cut dividends.
Change capital structure, that is, use more debt.
Cut its capital budget.
Issue new common stock.

Realize that each of these actions is not without consequences to

the companys cost of capital, stock price, or both.

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Answers and Solutions: 18- 11

SPREADSHEET PROBLEM

18-11 The detailed solution for the problem is available both on the
instructor s resource CD-ROM (in the file Solution for Ch 18-11 Build a
Model.xls) and on the instructor s side of the Harcourt College
Publishers web site, http://www.harcourtcollege.com/finance/theory10e.

Solution to Spreadsheet Problem: 18- 13

CYBERPROBLEM
18-12 The detailed solution for the problem is available both on the
instructor s resource CD-ROM and on the instructor s side of the
Harcourt College Publishers web site:
http://www.harcourtcollege.com/finance/theory10e.

Solution to Cyberproblem: 18 - 14

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Mini Case: 18 - 15